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What is Earnings Management?
Earnings management is the use of accounting trickery to make a company’s financial results appear better than is really the case. This is done by taking advantage of the accounting standards to either inflate a firm’s reported profits or to make these figures look less variable. The intent behind earnings management is to make earnings attain a specific target, even if the underlying performance of the business differs from this result.  In my opinion, this is an illegal practice.

There are several reasons why a company might engage in earnings management, which includes the following items:

Generate consistent earnings. Earnings management is especially common in publicly-held companies, because their investors base their stock valuation analysis on a reliable track record of consistent increases in earnings.

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Achieve bonus plans. The requirements of management’s bonus plans can drive them to manage earnings, in order to maximize their bonus payouts.

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Battle short sellers. Senior management might use earnings management to force short sellers out of their positions. When a positive earnings report drives up the stock price, short sellers are forced to abandon their short sale positions, given the risk of incurring major losses.

There are several ways to manage earnings. For example, managers could lower the capitalization limit, so that lower-cost expenditures are capitalized as fixed assets, rather than being charged to expense as incurred. Another possibility is to switch from the last in, first out method of valuing inventory to the first in, first out method, which tends to reduce the cost of goods sold during inflationary periods. Another option is to reduce the amount of recognized bad debt expense by shrinking the allowance for doubtful accounts.

Earnings management typically involves a change in accounting policy, which should be disclosed in the footnotes that accompany an organization’s financial statements. Consequently, a detailed analysis of the footnotes can reveal the existence of earnings management.  Before diving into what earnings management is, it is important to have a solid understanding of what we mean when we refer to earnings.  Earnings are the profits of a company. Investors and analysts look to earnings to determine the attractiveness of a particular stock. Companies with poor earnings prospects will typically have lower share prices than those with good prospects. Remember that a company's ability to generate profit in the future plays a very important role in determining a stock's price.

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That said, earnings management is a strategy used by the management of a company to deliberately manipulate the company's earnings, so that the figures match a pre-determined target. 

Excessive earnings management can lead a company to misrepresent facts on its financial statements, which can cause the Securities and Exchange Commission (SEC) to impose fines and other punishments.
Different types of earnings management include moving earnings from one reporting period to another in order to paint a better picture or manipulating the balance sheet to hide liabilities and inflate earnings.

Abusive earnings management is deemed by the Securities and Exchange Commission (SEC) to be "material and intentional misrepresentation of results." When "income smoothing" becomes excessive, the SEC may issue fines.

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Unfortunately, it can be challenging for the individual investor to discover abuses on their own. Accounting laws for large corporations are extremely complex, which makes it very difficult for retail investors to pick up on accounting scandals before they happen. However, understanding the different types of earnings management can make it easier for investors to detect when a company is using these techniques to manipulate its results.

Financial statement manipulation comes in a variety of forms. Investors who know what to look for can sometimes detect earnings management by performing a financial statement analysis of a company's quarterly and annual reports.

Given that earnings management can skew a company's true financial picture, it's important that investors perform as much due diligence as possible before making an investment decision. As the great Warren Buffett once said, "Managers that always promise to 'make the numbers' will at some point be tempted to make up the numbers."
 

By Jason Torrents