Earnings management can be defined as accounting techniques used to present a positive view of a company’s financial statements. These techniques allow companies to attract investors, hide the pain points of the firm, or to indicate financial stability. The use of these techniques has been prevalent for several decades. These techniques are used by companies operating across sectors, including financial and non-financial companies. Although regulators have attempted to develop stricter regulations and accounting laws that could deter companies from practising earnings management, such techniques continue to exist. Companies continue to mislead their stakeholders and negotiate better contracts on the basis of inaccurate information. Although earnings management can be useful for firms, its use also has a detrimental effect on the credibility of financial statements. Furthermore, it could also have an adverse impact on a company’s relationship with its key investors (Dechow et al., 2012). This essay aims to analyse the different types of earnings management techniques deployed by companies and top executives. In addition to this, the essay also focuses on the types of earnings management techniques that are used in the case of non-financial companies. Finally, the essay presents key conclusions and findings.
Different Types of Earnings Management Techniques
It is important to study examples of earnings management. Consider the example of a company that records net profits of $2 million during the first year of its operation. During the second year, the company’s profits decline significantly to reach $0.5 million. The company’s top management may be worried about the inconsistencies in terms of its bottom line. In order to address the situation, the company may look to report profits of $1.25 million for both the years. This would be executed by means of spreading revenues and costs proportionately over the two years. The company could make use of earnings management techniques to show consistent profits over the two years of its existence. Although the overall numbers for the two years would still be accurate, the proportion of profit achieved in each year would be “managed”. This would present a better picture to the investors, who may form an opinion that the company is highly consistent and stable. This example indicates that earnings management is not about reporting false information. Instead, it is a technique used to move money around in such a manner that the key targets set by the company are met. By using such techniques, managers tend to achieve their personal goals, without worrying about the accuracy of the numbers that are being reported by the firm (The Nest, 2019; Bukit and Nasution, 2015).
One of the most commonly used earnings management techniques is accrual-based management. In this case, the primary objective of a company is to ensure that the actual performance of the firm is not revealed to its investors. This type of technique is executed by means of altering accounting methods, or by reporting inaccurate estimates with regard to accounting accruals. This type of technique is easier to detect for the regulators, thereby making it riskier for firms to use it. Further, the accrual-based earnings management technique is less effective in the case of companies that do not have high inventory levels or long credit cycles. It is also important to note that accrual management takes place towards the end of a fiscal year or quarter (Zang, 2011; Edogbanya and Kamardin, 2015).
Another type of commonly used earnings management technique is Real Activities Manipulation. This technique is much harder to detect compared to the accrual-based technique. This technique is executed by means of restructuring major economic transactions, altering the timing of an investment, or by manipulating financial transactions. The idea behind this technique is that the management wants to intervene in the financial reporting process in order to present a positive picture of its operations to the key stakeholders. The key executives of firms engage in Real Activities Management in order to ensure that the company’s financial statements are in sync with its targets. For this purpose, they may alter the timing of major decisions such as M&A activity, forming partnerships, or setting up new subsidiaries (Gunny, 2010).
Real Activities Management has several advantages compared to accrual-based management. Firstly, this kind of earnings management technique is rarely detected by the regulatory bodies such as the Securities and Exchange Commission (SEC). Secondly, a firm’s ability to manage its accruals can be extremely limited. The accrual management process cannot be implemented for all financial transactions. Thirdly, Real Activities Management can be executed at any point during a financial year. Conversely, accrual management must take place near the end of a financial reporting period. All these advantages mean that companies and top executives are more likely to engage in Real Activities Management (Gunny, 2010; Nikoomaram et al., 2016).
Apart from the above categorisation, the different earnings management techniques used by firms can also be classified according to the ultimate goal of the technique (Patrick et al., 2015). The two major types of earnings management under this classification are efficient earnings management and opportunistic earnings management. Efficient earnings management refers to a situation where companies want to improve the informativeness of their financial statements. This is achieved by presenting private information in such a manner that the investors are aware of the company’s financial performance. The second type of earnings management is known as opportunistic earnings management, and it comprises the use of reporting the financial statements in an opportunistic manner. In this case, the top management of the company is focused on meeting targets and maximising their own personal utility (Scott, 2000; Hu et al., 2015).
In recent years, another earnings management technique has taken shape. This technique is known as the Horizon-Induced Optimism technique. Companies making use of this technique engage in earnings management practices aimed at increasing income. The key determinant which allows managers to make use of this technique is the time difference between an earnings management decision and a possible future reversal. Managers tend to be optimistic about their abilities in terms of spreading out company profits over multiple reporting periods. Therefore, they engage in earnings management techniques that allow them to lower their profits in one period and then compensate for these in the next reporting period. Managers are making use of this technique in order to make sure that the company’s financial statements appear to be stable. This allows them to attract more investors towards the firm, thereby improving their personal prospects (Scott Asay, 2018).
Use of Earnings Management in Non-Financial Companies
Earnings management is commonly practised by financial companies such as banks and lending institutions. However, it is also important to analyse the existence of such techniques in the case of non-financial companies. In countries such as Brazil, earnings management techniques have been widely used by non-financial companies (Pelucio-Grecco et al., 2014). Similarly, in the case of Pakistan, companies operating in non-financial sectors such as energy and industrials have been deploying earnings management techniques in order to ensure that their financial statements are optimised (Tahir et al., 2011). Non-financial companies are completely different from their financial counterparts. Their primary assets are not in the form of lending and deposits (Degiannakis et al., 2017). Therefore, these companies need to identify earnings management techniques that are different from traditional banks. A positive view of these companies’ financial performance presents them with a better valuation. In order to achieve this, they engage in earnings management techniques such as timing their investment decisions. This helps them in ensuring that they are presenting a consistent account of key indicators such as profits (Shaikh and Shah, 2012; Coung and Ha, 2018).
After the implementation of the International Financial Reporting Standards (IFRS), the prevalence of earnings management techniques has been affected to an extent. Prior to the implementation of the standards, non-financial companies were indulging in multiple earnings management techniques. For instance, companies such as Enron and Xerox are seen as prime examples of firms that were not reporting their financial statements in an accurate manner. Apart from engaging in financial misconduct, these companies were also engaged in earnings management. After the onset of these scandals, regulators and investors became highly concerned about the existence of earnings management. This resulted in the development of the IFRS, and the managers’ ability to use earnings management was restricted (Pereira and Alves, 2017; Anh and Linh, 2016).
Another commonly used technique in the case of non-financial companies is expense management. Such companies look to manage their expenses in such a manner that they are altering their financial statements. One such example is the case of Kenyan companies. Non-financial companies in Kenya are extensively involved in expense management practices. These companies do not follow proper inventory management techniques, mismanage the accrued payable expenses and tweak the actual accounts payable in order to present a more positive picture to their investors and other stakeholders. Such techniques allow these firms to spread out their costs over multiple quarters or other reporting periods. By making use of such techniques, these firms are able to mislead their key stakeholders. The regulatory bodies in Kenya have not drafted appropriate rules and guidelines in order to stop such activities from taking place. This is the primary reason why companies continue to engage in earnings management in the country (Wangui, 2017; Outa et al., 2017).
Non-financial companies also engage in working capital-based earnings management techniques. For example, an analysis of 76 Indian companies listed on the National Stock Exchange (NSE) found that these firms are more likely to engage in opportunistic earnings management techniques (Mittal and Garg, 2017). This analysis comprised a total of 692 firm years between the financial years 2007 and 2012. The firms operating in India make use of weak accounting laws to smoothen out their earnings. This strategy was even more prominent during the global financial crisis of 2007-08. During this period, the non-financial companies operating in India began to find innovative methods to ensure consistent profits are being reported on their financial statements. The primary technique used by these firms was that they made use of discretionary accruals in order to spread out their investments. Working capital investment outlays are one of the fundamental indicators of a firm’s financial performance. These firms exploited this and ensured that their expenses and earnings were smoothened out (Das et al., 2017; Mittal and Garg, 2017).
Earnings management is considered to be an acceptable technique by some researchers and analysts, including Mendes and Rodrigues (2017). This is because the non-financial companies engaged in such techniques do not impact the financial reserves held by the general public. However, these techniques have also been criticised by others, including Othman and Zeghal (2006). This criticism was based on the fact that earnings management distorts the true financial performance of both financial and non-financial companies. Therefore, it is extremely important for the regulators to ensure that they curb such activities by formulating stricter regulations. Another possible remedy for such activities is to generate awareness among top executives and auditors. This would help in ensuring that companies refrain from engaging in earnings management (Pereira and Alves, 2017; Bello et al., 2019).
This essay aimed to analyse the different types of earnings management strategies adopted by firms around the world. From the analysis, it is evident that firms engage in accrual-based and real activity-based earnings management techniques. Furthermore, it is also evident that companies engage in such activities for two primary reasons. The first reason is that they want to ensure that their financial statements are efficient. On the other hand, the second reason is that the executives of these companies want to accomplish their personal goals and motives. The essay also reviewed the use of earnings management techniques in the case of non-financial companies. From the review, it is evident that non-financial companies are also engaging in such activities in order to depict a consistent financial performance. Nevertheless, the implementation of new accounting standards, such as IFRS has curbed the use of such techniques.
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