Spotting Earnings Management
Manipulating Earnings: From Legal Techniques to Outright Fraud
Sep 23, 2009
This article examines why a company might want to manipulate earnings, and the spectrum of degrees in which a company can manage earnings.
Factors that Motivate Earnings Management
1) Meet Internal Targets by a company or one of its departments
2) Meet External Expectations: a wide variety of stakeholders have an interest in a company’s performance
3) Provide Income Smoothing: investors like a continual growth in earnings, so a careful timing of expenses and revenues is often transacted
4) Window dressing: If a company is looking for new financing, they will have an easier time getting it if their financials look good.
The Earnings Management Spectrum
Earning management occurs on a continuum, from savvy transaction timing, to aggressive accounting, to deceptive accounting, to fraudulent accounting, to outright fraud.
Savvy transaction timing is usually called “income smoothing,” and its purpose is to make for a smooth trend in earnings over time; investors like to see a continual upward growth in earnings. One method is called the “cookie jar reserves.” Management recognizes estimated expenses in a year when revenues are high, so fewer expenses are recognized in a quarter when earnings are lower. Another way to accomplish this goal is to defer revenues for “tougher times.” Another technique used is called " the big bath:" A company accelerates expenses and losses in a year with already poor results so that future income looks better and smoother.
Almost all corporations do some form of “income smoothing,” It’s perfectly legitimate, even though it really doesn’t accurately portray a company’s earnings in a given quarter or year.
Aggressive Accounting: Consists of changing accounting methods (such as from LIFO to FIFO) or revisions to estimates concerning bad debts, or depreciation lives; again, to change reported earnings for the better. With a little detective work, investors can find out about these practices, as they are fully disclosed in the notes to the financial statements.
Deceptive Accounting: Happens when changes in methods or estimates are made with little or no disclosure in the financial notes. This can be misleading to financial statement users. Not being aware of these changes can lead to inaccurate analysis, which can lead to faulty investment decisions.
Fraudulent Accounting: This consists of Non-GAAP accounting. WorldCom comes to mind as an example. In 2002, they recognized $3 billion as assets that were actually expenses.
Fraud: Consists of fictitious transactions: This might include measuring transactions in the wrong accounting period, or just plain making things up. Enron, for example, made up transactions to keep billions of dollars of debt off the balance sheet, so they could create the illusion of increasing earnings.
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