a) Discuss why the “management of earnings” has become prevalent in corporate reporting setting out examples of how this has led to dubious accounting practices. ...
a) Firstly, it is important to define what “management of earnings” is. It is defined by accounting literature as “distorting the application of generally accepted accounting principles” and Arthur Levitt, the old SEC (Securities and Exchange Commission) Chairman, defined earnings management as “practices by which earnings reports reflect the desires of management rather than the underlying financial performance of the company.”
There are many incentives for companies to manage their earnings, including external forces, internal factors, and personal factors. These are outlined below:
External Forces
• Analyst forecasts – Companies are under extreme pressure to meet analysts’ earnings estimates in order to prevent large drops in their stock price.
• Debt markets and contractual obligations – Companies depend on achieving certain earnings figures to obtain access to debt markets, or even to meet their current debt covenants and other contractual obligations. ... Companies may want to manage earnings to stay above competitors. ... This can provide pressure for management to boost earnings to meet the company’s own expectations.
• Unlawful transactions – Some companies use earnings management to cover up their unlawful transactions such as embezzlement, fraud, misappropriation and bribery.
Personal Factors
• Management bonuses – Stock option and bonus programs that are tied to earnings performance will provide incentive for managers to manipulate earnings numbers to boost their own compensation.
• Promotions and job retention – Managing earnings to make performance look better than it really is may lead to personal promotions, or even help to retain an employee’s current job.
Out of all the above factors, I feel that the main reason companies manage their earnings is to keep their shareholders happy by showing that the company is doing as well as it was expected to do. However, the shareholders put the management of the companies in a “no-win” situation as they are dissatisfied by the management of earnings but at the same timed are enraged when the company’s quarterly or annually earnings forecasts are not met.
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