The concept of Earnings management

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In this chapter the concept of earnings management will be discussed. Also, the motives for earnings management will be presented, as well as earnings management through pension accounting. This chapter will end with a summary.

Earnings management was defined by Schipper (1989) as: " purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain." A more recent definition is from Healy and Wahlen (1999): "Earnings management occurs when managers use judgement in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers."

There are several categories of earnings management. The first category concerns fraudulent accounting, or accounting choices that are not in line with GAAP. The second category concerns accruals management, or choices that fall within the boundaries of GAAP but that try to mask the true performance of an organization (Dechow & Skinner, 2000). The third category concerns real earnings management. If this is the case, managers undertake actions to increase earnings that are reported, but that deviate from the best practices. This last category changes the underlying operations of the organization to increase the earnings. The first two categories only have influence by the choice of the accounting methods the oragnization wants to use for these underlying activities (Gunny, 2005). Organizations will choose most of the time for the real earnings management category, because there are less risks involved for the organization than with the other two forms of earnings management. Real earnings management can be controlled more easily by the managers; the other two forms involve also decisions on the higher levels of the organization (Barton & Simko, 2002). One disadvantage of earnings management, especially of real earnings management, is that short term increases in income are reached at the expense of long term earnings and cash flows (Gunny, 2005).

There is not much literature on which kinds of accruals are used for earnings management (Healy & Wahlen, 1999). One of the studies that does address this issue is the research of Marquardt and Wiedman (2002). They researched the use of equity offerings, management buyouts and firms avoiding decrease in earnings. Both the costs and benefits of earnings management in using these accruals depend on the specific context. Firms using equity offerings as a means of earnings management increase income by accelerating revenu recognition. The increase in income are very high. Income is less high for the other two forms.

Motives for earnings management

There are several motives to be found to choose for earnings management. One of the main reasons or motives is the increase of the earnings of the organization. As was stated in the previous paragraph, most often organizations choose for real earnings management, because the risks are less high than for the other two forms of earnings management (Gunny, 2005). Graham, Harvey, and Rajgopal (2004) interviewed 401 financial executives and found that 78% was willing to change the economic value of the organization in order to change the perceptions of the financial reporting to meet objectives of the organization in relation to income. This is however done within the boundaries of the power a manager has within the organization (Glaum, 2008). The managers make actuarial assumptions in order to make use of earnings management. The choices they make are influenced by tax benefits, political costs, financial constraints, managerial self-interest and efforts to smooth any earnings.

But also other factors influence the motives for earnings management. One of these factors is the size of the firm. The greater the firm, the greater the chance managers will choose a form of earnings management to increase their income on the short term and to influence e.g. the prices in relation to accounting. Another factor of influence is the pressure governments can have on the organizations, especially larger (inter)national organizations (Watts & Zimmerman, 1978).

Incentives or motives for making changes through earnings management in pension decisions are because of the sensitivity of the earnings of the organization to the changes, merger activity, a decline in operating performance, or compensation contracts. These changes in managerial decisions relating to earnings management can influence other investment decisions (Bergstresser, Desai, & Rauh, 2006).

Earnings management and pension accounting

Earnings management is done by managers when they e.g. want to increase the earnings of the organization. In realation to pension accounting, they will in practice charaterize pension assets to capital markets. They will alter decisions concerning investments to justify any changes in order to increase the income. When income is assumed to be more on the long term, managers will make more use of forms of earnings management, especially when the effects on reported earnings are greater. Earnings management is also used in relation to pension accounting when stock options are involved. Decisions related to earnings management influence asset allocation within pension plans and therefore pension accounting (Bergstresser, Desai, & Rauh, 2004).

Coronado and Sharpe (2003) have shown that managers can increase the reported profits of the oganization by means of pension accounting. It is however difficult to find if and how this is done in financial reports of the organization. Changes pension assumptions can be changes by menas of prices, but als by means of operational earnings. Therefore it is difficult to define which means is used to make changes in pension assumptions. Pension accounting can be used to increase reported profits, but can also be used to increase stock prices.