Managing Earnings

Accounting has a long history of being an ethical profession. In recent years, however, some companies have asked their accountants to help "manage earnings."

What does it mean to manage earnings?

Who is more likely to be involved in such a situation, the financial accountant or the management accountant? Why?

Do you believe that managing earnings is ethical? Discuss the rationale for your answer.

The major role of financial reporting is to effectively communicate financial information to outsiders in a timely and credible manner. To do so, managers are given opportunities to exercise judgment in financial reporting. Managers can use their knowledge about the business to improve the effectiveness of financial statements as a means of communicating with potential investors and creditors. However, earnings management is also likely to occur when managers have incentives to mislead their financial statement users by exercising discretion over accounting choices in financial reporting like we have seen with such companies as Enron and Syntax.
Earnings management has attracted a lot of attention in academic research.
Early literature in the area of earnings management examined the impact of accounting choices on the capital market. Its primary focus was to differentiate between two competing hypotheses. The Mechanistic Hypothesis, which was common in the 1960s accounting literature, states that financial statement users do not utilize sources of information other than firms' financial reports. Investors arrive at their decisions based solely on the face value of firms' reported financial information. This theory shows how in such situations, investors can arrive at their opinions by utilizing other sources. The mechanistic theory predicts that the relationship between accounting earnings and stock prices is a purely mechanical one. That is, investors can be thoroughly misled by firms' accounting methods and choices. Being misled is last thing we
want.

A major offender, earnings management is the restatement category that regularly makes the news. Enron especially messed up with restatement issues. To define earnings management simply, earnings management can mean telling Wall Street what it wants to hear, when it wants to hear it. Managing the message by managing earnings is what really occurring. Everyday examples exist such as booking or deferring reserves for large expenditures that happen around a quarter- or year-end to meet the guidance to the Street for that period.

In more skeptical examples, the same reserves are made specifically to ensure that executives receive their maximum bonus payouts. Cases are now being documented that identify rolling changes to policy that modify earnings and result in better management payouts. The tangled web is bound tighter as undocumented system changes, made quickly to keep up with policy changes, transform and potentially undermine the integrity of underlying accounting entries. Years of unwinding and restating history coupled with the cost of repairing a company's reputation and shareholder confidence await those who resort lightly to earnings management.

I believe that managing earnings in unethical because accruals are often entered via manual journal entries, and bad accruals are a significant cause of restatements. Accruals are fine and acceptable techniques for matching revenues and expenses in the period in which they occurred. The fact that human estimations and judgments are used is where it gets tricky deciding whether or not managing earnings is ethical. Acting with only good intentions, low-grade resources with bad information tend to always set the course for audit review and issues which lead to the revelation of manipulation.