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Earnings management strategy is adopted by many companies in this profit- oriented business world. First of all, earnings are the profit of an organization. That is the reason why it is the indicator for external parties like investors and analysts to determine the attractiveness of a particular stock. Companies with good earnings prospects will typically have higher share prices in market than those with poor prospects. The crucial thing is company's ability to generate profit in short term and long term plays important role in determining the price of share in the market. Companies use earning management as a strategy used by the management of the company to deliberately manipulate the entity's earnings so that the figures match a pre-determined target figures. This practice is carried out for the purpose of income smoothing. Thus, rather than having years of exceptionally positive or negative earnings, organizations will try to keep the figures relatively stable by adding and removing cash from the reserve accounts. These characteristics of earning management make it the advantages of earnings management. And management of companies will take consideration into using earnings management.
Securities & Exchange Commission ( SEC) deems the abusive earnings management as it is the material and intentional misrepresentation of results. So, when the income becomes excessive, the authority of SEC will issue fines. But unfortunately, there is not much individual investor can do. Laws and regulation of accounting are extremely complicated and complex, which makes it very tough and difficult for regular investors to pick up on accounting scandal before they happen. Although the methods used by managers for income smoothing are vary and can be very complex and confusing, the most important thing to keep in mind is the driving force behind managing earnings is to meet a pre-determined target result. Therefore, careful, detailed research and accurate estimation must be done in order to achieve the pre-specified target.
Earnings management activities may occur because managers have flexibility in making accounting or also known as operating choices. Managers in an organization may adopt a depreciable life for a new computer chip plant that is at the high end of industry norms in order to minimize depreciation expense and thus maximize the reported earnings for short term period and long term period. The purpose of doing this is to manage earnings which will give impact to share prices in the market in a direction desired and required by current and potential shareholders.
The other possible objective is managers are trying to channel private information financial statement users. It is very vital and useful for readers of financial statements to determine which type is being practiced and to understand its significance. For illustration, the managers may adopt a depreciable life for a new computer chip plant that is substantially less than industry norms due to inconsistent changes in technology industry make it likely that the plant will be obsolete sooner than has been the norm for the industry. The motive here is to provide stakeholders information not otherwise available so they can adjust their expectations appropriately. Careful disclosure of such information may lower earnings and the share price for the company, but if the information conveys significant new news to analysts and other users of financial statements, they may also adjust earnings estimates downward for other companies in the industry, so that the company manifesting the information may actually feel some positive impact on its share prices due to its higher "quality of earnings" as it perceived.
The first impression of earnings management to both accountants and non-accountants is that it is "foe". For accountant, it is because of their attachment to reliability and non-accountants because of the association with fraud. One can choose to make argument. However, it is the natural outcome of the flexibility (choices) inherent in GAAP and exercised with appropriate economic evaluation. Actually earnings management is the "friend" to both accountant and non-accountant, including the stockholders whose wealth might be better maximized. In fact, given the financial manager's theoretical goal of stockholder wealth maximization, one type of earnings management which is income smoothing, is desirable, because it reduces the variability in the future expected cash flows, drives down the cost of equity and debt, and maximizes share price. In addition, changes in compensation structures in the recent years towards stock-based compensation have added the inducement to maximize short-term stock price. According to Matsumoto (2002), certain firm characteristics with the incentive to avoid negative earnings surprises. The capital market's accent on short-term profitability makes earnings management a way of life for the practitioner. Parfet, in " Accounting Subjectivity and Earnings management: A Preparer Perspective" states: " Corporate prepares operate from a sense of obligation to produce continuous improvement in operating performance, steadily and reliably increasing financial returns, and long term growth in shareholder value which creating a high-pressure working environment". The author also contrasts ' bad' earnings management which means the intention to hide real operating performance with the 'good' which means reasonable and proper practices and calls attention to the context in which decisions are made, where subtle effects from human perceptions and peer pressures, the complexity of combined factors, and the high-stakes business environment all impact good people who are trying to perform their responsibilities and jobs with integrity. This leads us to the real issue: earnings management as a continuum, with economic reality as reflected through appropriate GAAP approved alternatives at one end and intentional revenue or overstate of asset.
The other benefit that we can obtain from applying earnings management in organization is to avoid losses. Managers' earnings management behavior is merely related to costs and benefits. For sure, organization wants to cut unnecessary costs and maximize revenue. The example of the costs is the time consumption for managers take in planning and implementing earnings management actions and the effect on managers' reputation if and when manipulation is being investigated. The advantages can be grouped by taking into consideration the direct beneficiary of earning management: managers and the firm. Amongst the incentives related to managers' private benefit, maximization of bonus compensation and hiding poor performance to keep their jobs should be mentioned. Amongst those related to direct benefit for the firm, the most fundamental are the avoidance debt covenants violations, market penalization for reporting losses, breaking a string of positive earnings or not meeting analysts' forecasts, increase in transaction costs with stakeholders and a rating change in credit markets. There is a motivation or incentive to undertake earnings management when the benefits outweigh the costs.