The Definition Of Earnings Management Accounting Essay



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."

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In 1999, Healy and Wahlen 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-Dichev (1997); Dechow-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."

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."

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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] ]

In 2008, McNichols and Stubben 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 present and potential investors and creditors in making decisions in their capacity as capital providers."[ [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 relieves that, principals use reported accounting earnings for evaluating the firm's performance which consists of two components; a cash component and an accrual component. Thus, 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] However, Leuz et al. stress in 2003 that, "Managers can sometimes use discretionary accruals to increase the informativeness of financial reports."

Investigating the earnings management has been the question of how earnings management affects the information content of earnings. Earnings management may hinder the quality of the earnings information, which in turn reduces the quality of the financial analyses based on earnings figures.

If earnings management leads to lower quality accounting numbers, then one should expect a negative correlation between an earnings management proxy and other measures of accounting quality.

Because this behavior may have a significant effect on the quality of information provided to investors, the SEC recently is more concerned with earnings management behavior of firms' managers (Healy & Wahlen, 1998).

Information Asymmetry

Earnings management is closely related to the information asymmetry between managers and firm's other interest groups. Scott (1997) sees the earnings management as managers taking advantage of an asymmetry of information with shareholders.

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.

Schipper (1989) states that there is information asymmetry between managers and other interest groups and that asymmetry cannot be totally eliminated by changing the contractual agreement.

managerial discretion in financial earnings may lead to information asymmetry about cash flows between inside managers and outside existing and/or potential investors.

As such, earnings management may encourage corporate insiders engage in tunneling activities and/or overinvestment because it makes information about cash flows private to insiders. Increasing borrowing perhaps serves as an external control mechanism mitigating the free cash flow problem since interests must be repaid to avoid default (see, e.g., Jensen (1986) and Jensen and Meckling (1976)). Through reducing agency costs of free cash flow, debt generates positive values for firms with high levels of earnings management. Controlling for deadweight costs of debt, such as bankruptcy costs and agency costs of debt, more earnings management activities increase the demand for using debt as an external control mechanism.

Quality of Audit Process

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the concern about the quality of accounting numbers and its relation with the quality of the auditing process is increasing over time following the periodical clusters of business failures, frauds, and the litigation (Tie 1999, Chambers 1999).

Healy & Wahlen (1999) state that because the auditing is imperfect, management's use of judgement creates opportunities for earnings management, in which managers choose reporting methods and estimates that do not adequately reflect firms' underlying economics

The auditing process is supposed to serve as a monitoring device (Wallace 1980) that will reduce managers' incentives to manipulate reported earnings

Wallace (1980) claimed that investors demand audited financial statements because these statements provide information that is useful in their investment decisions. This implies that the audit process adds some value to accounting information and is valued as a means of improving the quality of the financial information.

Degree of freedom of accounting rules

earnings management largely depends on the degree of freedom that the accounting rules grant management in accounting estimates. In this sense, accounting standards must ensure an adequate reconciliation of rigidity and flexibility requirements: on the one hand, 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. On the other hand, excessive flexibility, "loosening the mesh" of accounting options and possible treatments, involves greater subjectivity in accounting estimates (Healy-Wahlen, 1999).

worldwide level clearly 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 (in this regard, Daske et al., 2008, distinguish between serious adopters and non-serious adopters).

Ethical issue

While some view earnings management as an unethical practice resulting in negative consequences, others posit a contrary view.

Merchant and Rockness (1994, p. 92) contend that earnings management is "probably the most important ethical issue facing the accounting profession."

Conversely, Parfet (2000) 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 definition of earnings management. These definitions can be summarised broadly into three classes:

Firstly, earnings management is a tool

Duo to (Ronen & Yaari, 2008) studies three different definitions of earnings management will be mentioned in order to find the best description for its concept:

1. First of all, earnings management is a tool used for flexibility of accounting information which managers apply as signals of their own exclusive information from their respective organization to shareholders.

2. Second definition relies on the managers' utilization of accounting tools in ways that they could apply them in both aspects of opportunistic and optimistic managerial goals.

3. And finally, earnings management is a manipulation of 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.

Varian (2002) suggests that managers are more willing to disclose disappointing news in settings where the market is expecting it, such as during economic downturns where many companies record large write-downs of balance sheet accounts.

Recessions make the business environment more challenging for firms, while managers try to cope with it managing financial statements according to this adverse economic situation. Investors, auditors, policy makers and stakeholders would be benefited from knowledge of EM under economic downturns.


Prior literature has provided an enormous amount of evidence of different incentives behind earnings management