Earnings Management

Is earnings management good or bad? Who (or which part of corporate governance mechanisms) is responsible to constrain earnings management? To what extent can the auditor constrain earnings management? Propose some methods for the auditors to detect and constrain earnings management. Does market react to firm's earnings management behavior?

In order to discuss earnings management and what its affects are on business and whether or not it's a good thing, one must first understand what earnings management really is. Earnings management is often referred to as creative accounting or income smoothing. By definition, earnings management is "strategies used by the management of a company to deliberately manipulate the company's earnings so that the figures match a pre-determined target" (Investopedia.com). One of the main reasons that managers or companies manage their earnings is to meet a pre-specified target, which is often set by an analyst. Companies find it important to make their numbers because their earnings are the companies' profit which analysts use to determine the attractiveness of that specific company's stock. If analysts don't like the earnings produced by the company, they find the stock to be unattractive which will affect the share price and low share price doesn't make the company or management look good.

There is good earnings management and bad earnings management. Earnings management is bad when it becomes abusive, because at that point, it's illegal according to the Securities and Exchange Commission (SEC). According to the SEC, abusive earnings management is "a material and intentional misrepresentation of results" (Investopedia.com). When the SEC sees that a company was involved in abusive earnings management, they usually issue fines but investors have already received the false numbers and made their decisions based on those numbers and there is nothing they can do to recover potential losses. Improper earnings management, or abusive earnings management, just does not happen on its own. Improper earnings management is seen as bad and unproductive. Most improper earnings management can be blamed on corporate management along with analysts and investors who have set high expectations for the company. Bad, or improper, earnings management is when someone actually intervenes with the financial reporting to hide the real operating performance of the company by creating artificial accounting entries or stretching estimates beyond a point of reasonableness. Disguising real operating trends with artificial and undisclosed accounting offsets is what makes up bad earnings management. Companies who participate in bad earnings management can often be found having hidden reserves, improper revenue recognition techniques and their accounting departments probably made either overly aggressive or overly conservative accounting judgments. Actions such as these are often illegal and constitute fraud and, at best, are considered bad business practices and will ruin the reputation of the company. Lastly, actions such as these are unproductive and create no real long-term value for the company, which should be the company's ultimate goal. Earnings management isn't always bad. There is also the other end of the spectrum, where good earnings management practices are found. Good earnings management techniques include "reasonable and proper practices that are part of operating a well-managed business and delivering value to shareholders." Many companies participate in good earnings management, also known as operational earnings management, in their day-to-day activities. Some examples of good earnings management are setting reasonable budget targets, monitoring results and market conditions, reacting to all the unexpected threats and opportunities that arise and reliably delivering on commitments. A company has to participate in some sort of earnings management, and more than likely, it's the good kind. A company participates in good earnings management because it has to set a budget and has to set targets. It has to organize its internal operations and have a way to motivate its employees. Lastly, company participates in good earnings management is because it provides a way to present information to its present and potential investors about their operations. Actions such as these that achieve stable and predictable results and positive earnings trends through good planning and operational responsiveness are not illegal or unethical in any way, its just part of business. All businesses try to reach their targets and try to continue seeing growth while responding to their competition and changes in the market. Good earnings management just allows the company to continue their operations with some type of goal to achieve or target to reach. This only becomes a bad thing when those goals or targets are not reached and someone starts making up the numbers.

Overall, only improper or abusive earnings management is a bad technique. Managers and companies should focus on the long-term value creation that benefits investors over the short-term earnings management that satisfies financial analysts. Quarterly or periodically managing earnings is a bad idea for many reasons. First, quarterly predictions narrowed down to a couple of cents per share don't say much about the company's long-term prospects or ability to generate profits. Second, as mentioned above, it's illegal to abusively manage earnings and if the company does get caught for doing so, the actions of the company end up costing the stockholders money and the company has to deal with legal action and lawsuits. No one benefits from these outcomes, except maybe the lawyers. Third, earnings management has a negative effect on the company in the long run. While managers are concerned with keeping short-term profitability up they are starving R&D and marketing of necessary resources. These managerial actions only hurt the long-term future of their company; investors expect long-term value creation and that requires long-term strategy that is accomplished in R&D and marketing.

Earnings management is a corporate decision that turns bad if erroneous decisions have been made to falsify fictitious earnings. If managed wisely, earnings management can be a good thing. However, companies are under a lot of pressure to set quotas, meet standards, and satisfy the needs of their investors. This may lead to unethical accounting decisions. In order to prevent such a thing, a governing body must be established. This governing body must up hold the responsibilities of correctly stating financial statements and detecting inappropriate activities within companies. A concept known as the corporate governance follows such principles.

Corporate governance consists of all the people,