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The Slippery Slope of Earnings Management

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Earnings are the most significant item in the financial statement. Increased earnings represent an increase in a company value, while decreased earnings signal a decrease in that value. Statistics say that “majority of the companies use earnings management to maintain steady earning growth or to avoid reporting red ink” (WIEM, 2012). Thus, it is obvious that companies have a vital interest in their reports and even must learn earnings management schemes.

There are different definitions of the earnings management; there are also many opponents of it. The supporters of the earnings management distinguish legal and illegal or so called “cooking the books” earnings management. They interpret legal earnings management as “reasonable and legal management making and reporting intended to achieve stable and predictable financial results” (WEMI, 2012) and refute the opponents’ criticism confirming that true earnings exist only as theoretical concept. Taking this into consideration, the earnings management, which is blamed at the reducing of the company’s transparency by obscuring its true earnings, is justificative, such as practically can not be based on the real data. The earnings management is considered to be income smoothing, the numbers game, aggressive accounting, creative accounting, borrowing income from the future, accounting alchemy and so on. Heally and Paelu explain that it “occurs when managers use judgment 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 numbers” (Bouwens, 2012). As a rule, it is done to reduce the tax liabilities and manage relations with investors and workers, increasing the value of the firm at the same time.

Slippery Slope

Considering two points of view, what is bad in the earnings management? And when does it become illegal? SEC sanctions against companies and firms which break the generally accepted accounting principles are accusing them in fraud. Fraud is “the intentional, deliberate misstatement or omission of material facts, or accounting data, which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgment or decision” (WIEM, 2012).  According to SEC, the main fraud feature is intended to deceive. Recording fictitious sales, backdating sales invoices, assets overvaluing, improperly capitalizing expenses and other similar actions are considered to be illegal and are sanctioned.

The main problem of the earnings management is that there is no clear posted limit beyond which a choice is obvious illegal, no measures of what is appropriate and what is not. Thus, earnings management actions are considered illegal when the estimate amount is extreme and legal when it is reasonable. The slippery slope of it may lead to a fraud accusation and loss of the company’s positive performance. It is an executive’s decision to engage in a small amount of earnings management. In most cases the manager strongly believes that his or her firm is just experiencing a bad quarter and to cover up the problem is the best decision for everyone involved: employees, customers, creditors and shareholders. But often things do not turn around as was expected and manager continues to manage earnings in increasing amount, which leads to a fraud commitment and heavy penalties paying. The slippery slope of the earnings management is in its quick progress to severe earnings management, which is not easy to stop and turn into the overly aggressive revenue recognition practice. Catherine Schrand writes that “managers often …. are not necessarily trying to hurt anyone, but they ended up being in a position where they felt it was the only way to get out of a bad situation” (Schrand, 2010). Analyzing the reasons of the slippery slope, SEC recognizes two types of the fraud: premeditated, which aimed to deceive from the beginning, and accidental, which is mentioned earlier.     

Cases Of Earnings Management Success And Failure

Instead of high risks, the majority of companies continue earnings management providing. Some managers’ overconfidence ruins the firm’s reputation at once, others cope to juggle for several years and just the few are lucky to turn their firms around.

According to SEC, two of the largest corporate frauds in the U.S. history are Enron and WorldCom. Waste Management showed not bad result, too. Its earnings from 1992 to 1997 counted 1.7 billion – the largest restatement in the corporate history. But later it figured out that the top executives led the systematic fraud by setting earnings target to each quarter. They discovered the scheme and manipulated accounting practices, but the company’s revenues and profits were not growing so fast to meet these targets.

The slope of the earnings management engaging is too slippery and just a few quick-minded managers cope to save their firms. The exceptional examples of luck are Standard & Poor’s 500 Stocks and General Electric’s. Operating profits of the first were inflated by 10% per year for the past two decades with the help of a mix of one-time write-offs and other accounting tricks. The price of S&P’s 500 Stocks has been constantly enhanced not without help of the earnings management techniques. General Electric’s achieved $10.7 billion in earning for fiscal year 2006 and had a 48, 2 percent of the total return over the previous five-year period. After doing this, the company’s chief executive, Jack Welch, was considered a management genius.

Conclusion

Earnings management may be legal and illegal, it may save the company or destroy not its nowadays but also future performance. No matter premeditated or accidental fraud is, it remains fraud. Many managers can not choose between the desire to meet a performance benchmark and desire to think of self safety and honesty. But when the decision of the earnings managements’ techniques use is taken, it is important not to go too far and rationally estimate all the risks taken. Financial reports should provide investors with relevant, but not desirable, information to assess the economic performance of the firm. Rationalization should be a key driver of the earnings management behavior, such as even the strongest beliefs are not always confirmed by actions. The primary decision is to stop the deliberate smoothing of the earnings. If it will not help, it changes over time to the seduction of drawing off  and serves as a contributing factor to the slippery slope of earnings management, which is forced by the imaginary monetary reward.   

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