Earnings Management
| Author | Robert Sack |
| Pages | 213-215 |
Page 213
Earnings management is the practice of inappropriately managing the earnings number reported in the company's income statement, and is quite different from the process of managing the company's underlying business. The Panel on Audit Effectiveness, established by the Public Oversight Board in response to a concern expressed by the Securities and Exchange Commission (SEC), found no single definition of the term, but cited several examples, including this from attorney Michael R. Young:
There are two types of managed earnings. One type is simply conducting the business of the enterprise in order to attain controlled, disciplined growth. The other type involves deliberate manipulation of the accounting in order to create the appearance of controlled, disciplined growth when, in fact, all that is happening is that accounting entries are being manipulated [italics in original]. (Panel on Audit Effectiveness, 2000)
In an interesting overview article, Patricia Dechow and Douglas Skinner suggested that there is a fine distinction between fraudulent accounting and earnings management: Both involve the intent, by reporting management, to distort their company's earnings picture, but fraudulent accounting does so by violating generally accepted accounting standards (GAAP) while earnings management does so within GAAP. (Technically, fraud requires scienter—proof of an intent to injure. It is a legal determination, and would be subject to an analysis of all surrounding circumstances.)
In a landmark 1998 speech, the then chairman of the SEC, Arthur Levitt, Jr., said:
While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their [earnings] estimates. I recently read of one major U. S. company that failed to meet its so-called "numbers" by one penny and lost more than six percent of its stock value in one day.… the different pressures and expectations placed by, and on, various participants in the financial community appear to be almost self-perpetuating.
Also in that speech, the chairman suggested this slippery slope:
Analysts ask managements of the companies they follow for guidance, as they project future earnings for the company and projections are influential in analysts' recommendations.
Investors use those research reports in their decisions.
The management people running those companies try to meet the analysts' earnings projections to (i) maintain their credibility with the analyst community, and (ii) maintain the relative price of the company's stock.
Page 214
Where the normal operations of the business do not produce earnings equal to the investment community's expectations, managements are pressured to find ways to manage the reported earnings.
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