Definition Of Earnings Management Accounting Essay

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For numerous years, earnings management has been of grave concern for regulators and practitioners, and has received substantial attention in the accounting literature. Healy and Wahlen (1999: p.380) in their study "A Review of the Earnings Management Literature and its Implications for Standard Setting", pinpoint that "prior research has focused almost exclusively on understanding whether earnings management exists and why." They halt that earnings management remains a fruitful area for academic research and suggest that future research contributions is crucial for the determination of the potential factors that restrict earnings management.

Definition of Earnings Management

Central to this study is the definition of earnings management. Beneish (2001) and Healy & Wahlen (1999) argue that, there is a wide body of literature with regard to earnings management but no consensus on the definition of earnings management and there are several different definitions. For instance, Davidson et al. in 1987 express that, "earnings management is the process of taking deliberate steps within the constraints of generally accepted accounting principles to bring about desired level of reported earnings." In the same veins, Dye (1988) and Scott (1997) averred that, "earnings management is the choice by firm of accounting policies so as to achieve some specific managerial objective." Scott (2011) further states that, "earnings management as the choice by a manager of accounting policies, or real actions that affect earnings so as to achieve a specific reported earnings objective."

Healy and Wahlen (1999) express that, "earnings management refers to the judgment used by managers to alter financial reports to either mislead some stakeholders about the economic performance of the firm or to influence contractual outcomes that are contingent on accounting numbers."[ [1] ] Further, in the same year, Degeorge, Patel, & Zeckhauser in there study find that, "earnings management as artificial earnings manipulation by managers to reach the expected level of profit for some special decisions like effects on analysts' forecasts or estimation of previous earning trends." Thus, they believed that the main goal of earnings management is investors' imagination management.

Back in 1989, Schipper states that managing earnings is a "purposeful intervention in the external financial reporting process with the intent of obtaining some private gain." In the same light, Dechow et al. (1995); Burgsthaler and Dichev (1997); Dechow and Dichev (2002) averred that, "the term earnings management is generally used to indicate the use of discretion by those preparing the accounts in pursuing objectives of a personal or particular nature in order to obtain an advantage or mislead certain stakeholders in terms of knowledge of operations and corporate results." They continue to build upon this definition by stating, "earnings management qualifies those accounting policies that outside the scope of the quantitative determination of accounts are aimed at the methodical alteration of periodic corporate reporting."

On a reverse token, Fischer and Rosensweig (1995) defined earnings management as, "actions by division managers which serve to increase (decrease) current reported earnings of a division without a corresponding increase (decrease) of the long-term economic profitability of the division." As such, this definition identifies two important components of earnings management: consequences and intent. Further in 2008, Ronen and Yaari state that, "earnings management can be loosely defined as a strategy of generating accounting earnings and continue by arguing that earnings management is an umbrella notion for acts that affect the reported accounting earnings or their interpretation." However, other researchers have tried to give an in-depth insight of earnings management from various perspectives as discuss below:

Agency Problem

Earnings management may emerge as an upshot of agency problem. The term agency problem also known as principal-agent problem is defined as, "an agency cost where the misalignment of interests between the agent (e.g., manager) and principal (e.g., firm, superior, shareholders) leads the agent to maximize his/her own economic interests at the expense of the principal."[ [2] ] Jensen and Meckling (1976) ; Watts and Zimmerman (1986), further argue that, "an important aspect of managing these differing interests is the need to control the managers' behaviour through monitoring mechanisms." In the same veins, back in 1932, Berle and Means branded that, "the rights of shareholders have long been considered an important external governance mechanism to align the actions of managers with the interests of owners."

Earnings management is generally perceived as being undesirable from the point of view of investor's and stakeholders'. The underlying concept as capture of this 'undesirable' is that, "it may thwart their efforts to make a correct assessment of the firm's fundamentals and determine the stock's fair value."[ [3] ] Besides, Levitt in 1998 notes that, "the overall consequence of earnings management is the erosion of trust between shareholders and companies and that such trickery is employed to obscure actual financial volatility, thereby masking the true consequences of management's decisions." Loomis (1999) further echoes this viewpoint by stating that, "managers may obscure facts that stakeholders ought to know, leaving them in the dark about the true value of a business." [ [4] ]

McNichols and Stubben (2008) note that, "earnings management complicates equity valuation as it conceals the company actual performance and masks underlying trends in revenue and earnings growth that help to build expectations of future growth and product demand." Cheng highlights in 2005 that, "earnings are useful because they can capture truthful information relevant in assessing and predicting firm performance." However, Bernard (1995) averred that, "firms' deliberate earnings management activities may introduce errors into earnings and thereby reduce their ability to convey truthful information."

Notwithstanding, it is intrinsic to stress that the objective of financial report is "to provide financial information about the reporting entity that is useful to existing and potential investors and creditors in making decisions about providing resources to the entity."[ [5] ] However, Healy & Wahlen (1999) argue that, "managers use their knowledge about the business and its opportunities to select reporting methods, estimates, and disclosures that might not accurately reflect their firms' underlying economics."

Prior research in this field reveals that, principals' use reported accounting earnings for evaluating the firm's performance which consists of two components; a cash component and an accrual component. Moreover, it is vital to point out that a major portion of these accruals could be subject to management's discretionary power, and this brings to light management's ability to shift earnings between accounting periods to influence users' perceptions.[ [6] ] Thus, managing earnings may hinder the quality of the earnings information, which thereafter diminishes the quality of the financial analyses based on earnings figures. Yet, in 2003, Leuz et al. stress that, "managers can sometimes use discretionary accruals to increase the informativeness of financial reports."

Information Asymmetry

Prior literature also reveals that, earnings management is closely related to asymmetry of information between the agents (e.g., managers) and firm's other interest groups. In other words, as researchers have argued that, "management discretion in financial earnings may lead to information asymmetry about cash flows between inside managers and outside existing and/or potential investors." Besides, Dye (1998) and Trueman & Titman (1988) show analytically that, "the existence of information asymmetry between management and shareholders is a necessary condition for earnings management." However, Schipper (1989) stress that, "there is information asymmetry between managers and other interest groups and that asymmetry cannot be totally eliminated by changing the contractual agreement."

Quality of Audit Process

Furthermore, various literatures focus on the quality of the auditing process as a determinant of earnings management. For instance, Tie (1999); Chambers (1999) in there study pinpoint "the concern about the quality of accounting numbers and its relation with the quality of the auditing process which is increasing over time following the periodical clusters of business failures, frauds, and the litigation." The auditing process as argue by Wallace in 1980, "is supposed to serve as a monitoring device that will reduce managers' incentives to manipulate reported earnings." In other term, as the author argues that, "the audit process adds some value to accounting information and is valued as a means of improving the quality of the financial information." Hence, if the auditing is imperfect, managers may use elect reporting methods that do not adequately reflect firms' underlying economics (Healy & Wahlen, 1999).

Degree of freedom of accounting rules

Another stream of research on earnings management reveals that, managing of earnings may generally depends on the degree of freedom that management is being granted for accounting estimates by accounting rules. In a study by Tiziano Onesti and Mauro Romano (2012) demonstrate that, "despite high quality accounting standards, the urge to manipulate results is still vigorous in the presence of managerial incentives, also in relation to the accounting standards implementation method."[ [7] ] Back in 1999, Healy and Wahlen stress that, "accounting standards must ensure an adequate reconciliation of rigidity and flexibility requirements." They continue arguing that, "the adoption of excessively rigid accounting rules, whilst reducing management discretion, could lead to applications that are not particularly flexible and poorly adaptable to the variety of possible cases and also point out that, excessive flexibility, 'loosening the mesh' of accounting options and possible treatments, involves greater subjectivity in accounting estimates."

Ethical issue

Moreover, few researches posit that managing of earnings is an unethical practice which has negative consequences on the firm's image in the long run. Back in 1994, Merchant and Rockness contend that earnings management is "probably the most important ethical issue facing the accounting profession." However, this viewpoint was contested in 2000 by Parfet who suggests that "earnings management is not necessarily a negative phenomenon, but a necessary and logical result of the flexibility in financial reporting options. That is, if managers have a responsibility to maximize shareholders' value, then managers must choose among all legal options that will help achieve this goal."

Prior literature has provided an enormous insight on the various definitions of earnings management. These definitions can be condense in these few lines as argue by Ronen & Yaari in 2008, "earnings management is a tool used for flexibility of accounting information which managers apply as signals of their own exclusive information from their respective organisation to shareholders and also to manipulate accounting data in order to decrease transparency of financial reports and cause to mislead shareholders and other stakeholders in their decision making process that lead to enhance managements' personal profit."

Drivers of Earnings Management

In recent years, numerous accounting researches try to scrutiny the drivers of earnings management and the factors that induce managers' incentives to manage reported earnings, following the huge corporate collapses in the US (e.g. Enron and WorldCom). The business environment in itself provides various compelling incentives for agents (e.g. managers) to engage in earnings manipulation. To further echoes this viewpoint, the motive for earnings management is driven in part from management's duty to direct business activities in a way that achieves targeted outcomes. Intrinsically, another element that forms part of the reasons for earnings manipulation is that the value of the firm and the wealth of managers and shareholders are inextricably linked to reported earnings.[ [8] ]

Generally, a manager's incentive to manipulate earnings is closely related to ways in used information is used. For instance, management might increase the usefulness of financial statements in aim to attract new investors, as the latter will account for current earnings information when evaluating the firm's future prospects. Besides, earnings and cash flow information are of utmost importance to lenders in assessing the credit worthiness of the firm's. Furthermore, researches also conclude that earnings can be manipulated by strategically timing and structuring transactions. For example, Bushee in 1998 advances that, "management may opportunistically increase earnings by reducing research and development and other discretionary expenses."

Prior literatures demonstrate the existence of numerous incentives for managements' to engage in earnings manipulation, which can indeed be categorised under these three main headings:

Market Incentives

Contractual Incentives

Regulatory Incentives

Market Incentives

Scott B., Jackson and Marshall K. Pitman (2001) postulate that, "market incentives to manage earnings arise when firm managers perceive a connection between reported earnings and the company's market value." Friedlan (1994) further stresses that, "management might seek to manipulate earnings in the hope of receiving a higher price for their shares as reporting earnings and firm's value are closely linked." Other studies to pinpoint that manager may manipulate earnings in an effort to report positive earnings and earnings growth. For examples, managers can use their accounting discretion to bolster earnings if the companies are in danger of falling below their earnings target or in periods surrounding Initial Public Offerings (IPOs) in an apparent attempt to alter investors' perceptions. Therefore, IPOs is a core component for market incentives as discuss below:

Initial Public Offerings (IPOs)

Initial Public Offerings (IPOs) as outlined in accounting literature, occurs when firm security is traded to the general public for the first time, with the expectancy that a liquid market will develop. Notwithstanding, firms making these IPOs do not have an established market prices for these security, and one way for valuating them is to consider the furtherance prospectus of the business. Hence, earnings management during IPOs consists of window dressing or enhancing financial reports draw better valuation. However, this raises the question of whether the prices quoted in respect of those shares of the IPO firms are neutral.

Contractual Incentives

In "Auditors and Earnings Management", Scott B. Jackson and Marshall K. Pitman (2001) further postulates that "contractual incentives to manage earnings arise when contracts between a company and other parties rely upon accounting numbers to determine exchanges between them." In this viewpoint, managers can alter the amount and timing of those exchanges by manipulating the results of operations. These techniques mainly include debt covenants and compensation contracts which are discuss below:

Debt covenants

Debt covenants have long been at the centre of many debates during the last decades. Accounting researches have try to scrutinise the reason for debt covenants hypothesis that firms opt for their accounting choice or manage accruals to avoid violating covenants in debt contracts. Studies further reveal that firms close to violating or have violated those covenants are candidates for managing earnings as it involves huge cost to management or the firm as a whole. Thus, managers try to exercise their discretion by making income-increasing accounting choices that would relax the firm's indebtedness. Hence, as argue by Duke & Hunt (1990); Holthausen (1981); Jelinek (2007), firm's indebtedness is positively associated with earnings management. By the same token, if a company needs to borrow, managements have an incentive to enhance the liquidity reflected in the company's financial reports.

Managers try to convey a more favourable image of the financial position of the firm by shrinking the debt-equity ratio and boosting income through earnings management in aim to make interest coverage ratios look better that would facilitate access to loan granting. Accounting studies further reveal that, "to improve access to capital, executive tend to manage earnings in a manner that leads creditors to believe that a firm has strong potential to generate future net cash inflow." [ [9] ] Nevertheless, literatures also pinpoint that; the recent economic downturn is substantially esteeming the manipulation of cash flow generation with the aim of alleviating the financial stress of firms. As a result, managers may engage in earnings management through debt contracts to manipulate the accounting figures to enhance the faithfulness of the financial reports to mislead the lenders.

Compensation Contracts (Bonus scheme)

In today's corporation, shareholders put in place mechanisms that align the interests of the managers of the firm with the interests of the owners of the firms in aim to reduce agency costs and prevent managers from acting in their own interests. In other words, in line to maximise shareholders wealth and to minimise conflicts of interests between mangers and shareholders; corporation create compensation contract by linking managerial pay to the improvement of firm value. Studies further demonstrate that the bonuses for management compensation are determined, in part, by firm earnings. Hence by manipulating these accounting numbers, for instance in a scenario where managers are receive a bonus based on achieving certain earnings targets (i.e. rewarded on the performance of the firm), managers may inappropriately shifting revenue or expense figures to current or future periods which can influence their current and future compensation.

Prior researchers have provided evidences on the influence of compensation contracts on earnings management behaviour. The best-known empirical investigation is perhaps; "The effect of Bonus schemes on Accounting Decision" by Healy in 1985. He put forward that managers tend to maximise their bonus through opportunistic earnings management since they have insider information on the firm's net income. He further echoes this viewpoint by stating that if earnings fall within expected range, management will choose appropriate accounting policy to foster earnings. However, when earnings fall outside the expected range, managers tend to defer earnings to futures to maximise their bonus in the long run.

Holthausen, Larcker, and Sloan (1995) and Gaver, Gaver, and Austin (1995) in their studies confirm the hypothesis put forward by Healy (1985). They clarify that upwards and downwards earnings management around the upper bound do exist and further suggest that managers have incentives to manage earnings around a target to maximize bonus payments. In a recent study in 2008, Daniel, Denis, and Naveen echo that managements manipulate earnings upward when pre-managed earnings are expected to fall short of dividend payments. However, Goel & Thakor (2003) stress an opposite view in their study by stating that "managers choose reporting strategies that maximize their own expected compensation, taking into account the effect of earnings reports on investors' perceptions and subsequently management's compensation"

Regulatory Incentives

Scott B. Jackson and Marshall K. Pitman further assert in their article "Auditors and Earnings Management" that "regulatory incentives to manage earnings arise when reported earnings are thought to influence the actions of regulators or government officials." As such, by manipulating the outcomes of operations, managements may induce the actions of regulators or government officials, thereby diminishing political scrutiny and the effects of regulation. Notwithstanding, some researches echo in the opposite direction by highlighting that little room for manoeuvre exist for firms to minimise corporate tax. Back in 1997, Scott stresses that "tax authorities apply different accounting methods to calculate the chargeable profit of a business thereby reducing firms' room for manipulation." For instance, not all expenses incurred by a business are allowed to be deducted against profits and also for tax purposes, deduction like depreciation on tangible non-current assets is not allowed.


Since manipulation numbers is likely to happen under the market incentives, contractual incentives and regulatory incentives, it is fundamental for shareholders to have their financial statements audited and monitored by independent auditors. As a matter of fact, the latter will express judgement on the reasonableness of the accounting policies used by managements. Nevertheless, following the huge corporate collapses in the US (i.e. Enron and WorldCom) in recent years, investor's trust has fade to the accuracy of financial information published by firms as replying confidently on the auditor's work is becoming too questionable.

Pattern of earnings management

From the above discussion, it can be encapsulate that for the various incentives for earnings management, mangers may engage in different pattern for manipulating earnings in income statement. In the same line, prior study have documented that each type of manipulation has its associated benefits and costs. Hence, managers will manipulate earnings to meet or beat earnings benchmarks at the lowest cost to achieve the utmost benefits by engaging in the following pattern:-

Big Bath

Numerous empirical studies have documented that managers do used 'big bath' to manipulate earnings.[ [10] ] The term 'big bath' in accounting, is an earnings management strategy that manipulates a firm's income statement to make poor results look even worse. Accounting literatures consistent with the findings of DeAngelo et al. (1994) demonstrate that, "a new Chief Executive Officer (CEO) may take a 'big bath' in the year of change to increase the probability of higher future earnings when his/her performance will be measured, especially when low earnings in the change year can be blamed on the previous CEO." [ [11] ] However, another stream of thought, Kirschenheiter and Melumad (2002) show that "if true earnings are bad, the manager will take a big bath to introduce additional noise into his report and reduce the perceived precision of earnings report."

Income minimisation

Prior research works postulate that income minimisation is similar to taking a bath to some extent but is less extreme. Such a pattern may be chosen by managements in time of high profitability to write-offs of capital and intangibles assets, expensing of advertising and research and development (R&D) expenditures. Studies in this field further revealed that, "earnings decreasing, instrumental losses, especially in situations where in the presence of strong corporate restructuring and management changes, it is desirable to shift responsibility of negative results to the previous management and highlight the greater abilities of the new management or the beneficial effects of economic and financial restructuring or reorganisation."[ [12] ]

Income maximisation

Looking at the other end of the spectrum, managers may also manipulate earnings upwards. Income maximisation as coined by Tiziano Onesti and Mauro Romano in 2012 "is to artificially increase earnings, typically arising from the management's desire to present better results than actual in order to obtain private benefits (esteem, reconfirmation, additional remuneration) or to prevent unsustainable environmental pressures, especially from external lenders." Years back, Healy's study was a key element in this pattern of earnings management. The author put forward that mangers may engage in a pattern of maximisation of reported net income for bonus purposes and also firms close to debt covenant violations, may maximise income.

Income smoothing

Income smoothing is a form to manipulate earnings and is generally defined as "the dampening of fluctuations in reported earnings over time."[ [13] ] In other terms, earnings smoothing is the process of adjusting reported earnings to be greater or lower than expected, (Beidleman, 1973). As such, managers may incline to take actions to boost earnings when they are relatively low and to decrease earnings when relatively high. Hence, by smoothing earnings over time, managers convey information to stakeholders that is biased, which does not faithfully represent underlying economic performance of the company. As a result, the usefulness of the information to firm outsiders is condensed, thus it is argued that earnings smoothing diminishes accounting quality (Lang et al., 2003; Barth et al., 2008).

Drawbacks of Earnings Management

Prior literatures postulate that there are particular drawbacks when companies apply this technique, earnings managements, as it creates a major information gap between sellers (for e.g. firms) and buyers (for e.g. investors) at the stock market. By engaging in earnings manipulation, managements are likely to present financial report that will lack fair value, as it does not reflect the company's actual activities (Dechow & Skinner, 2000). An undeniable fact put forward by Nobes back in 1998 is that "shareholders or new investors do not have the same access to information as members in the board, thus this puts investors in a dilemma because they only have the financial report as the source for decision". Hence, when managers manipulate accounting figures in financial reports, the accounting information's credibility shrink.

Further studies stress that earnings management not only harm investors but the society as well, as the efficient resource allocation are distorts. As such, welfare will diminish if firms allocate resources to projects that are appearing to look good but which are in reality bad. Likewise, another stream of research reveals that when a firm seeks to manipulate earnings to increase current year performance, this necessarily done at the detriment of future years. In order word as stated by Barton and Simko in 2002, "the artificial increase in current year's earnings will result in a reporting flexibility, where earnings management in previous accounting period constraint the firm's ability to manage earnings in current period." Hence, by trying to boost current year performance by manipulating accounting figures, the firm may end up paying more corporate taxes.

Summary of Empirical Studies on Earnings Management

Different studies found empirical evidence that earnings management exists and managers have various incentives to manipulate earnings to boost the firm performance.[ [14] ] For instance, back in 1997, Burilovich looked at particular incentives to manipulate reported earnings in the case of alternative minimum tax. Using a sample of 72 regulated life insurance firms during the period 1984 to 1989, she found that income decreasing discretionary accruals (DA) differ significantly across the companies audited by big auditing firms. She further added that "auditing firms with the greatest market share appear to allow greater discretion to the client in determining accruals." Hence, managers will be tempted to manipulate earnings as the auditing firms are allowing such discretion.

Further, in a study of Korean industrial firms in 2002, Yoon and Miller provide significant evidence that earnings management is affect by the level of operating performance. As such, they found evidence supporting the big bath theory in that, when operating performance is extremely poor, firms took income lessening strategies rather than income increasing ones (.i.e. firms tend to take a big bath). This viewpoint was further echoes by Rosner (2003) who endorsed this hypothesis by highlighting that firm in financial distress were more likely to misstate their financial reports compared to less-distressed firms.