What Is Earnings Management?

Earnings management is the use of accounting techniques to produce financial

statements that present an overly positive view of a company's business activities and
financial position. Many accounting rules and principles require that a company's
management make judgments in following these principles. Earnings management takes
advantage of accounting rules and creates financial statements that inflate or "smooth"
earnings.
Earnings management is a practice followed by a company’s management to influence
the earnings reported in financial statements. It is executed to match a set target and is
different from managing the company’s underlying business. An earnings management
strategy uses accounting methods to present an excessively positive view of a
company’s financial position, inflating earnings.

Understanding Earnings Management

Earnings refers to a company's net income or profit for a certain specified period, such
as a fiscal quarter or year. Companies use earnings management to smooth out
fluctuations in earnings and present more consistent profits each month, quarter, or
year.
Large fluctuations in income and expenses may be a normal part of a company's
operations, but the changes may alarm investors who prefer to see stability and growth.
A company's stock price often rises or falls after an earnings announcement, depending
on whether the earnings meet or fall short of analysts' expectations.

Examples of Earnings Management

One method of manipulation when managing earnings is to change to an accounting
policy that generates higher earnings in the short term.
For example, assume a furniture retailer uses the last-in first-out (LIFO) method to
account for the cost of inventory items sold. Under LIFO, the newest units purchased
are sold first. Since inventory costs typically increase over time, the newer units are
more expensive, and this creates a higher cost of sales and a lower profit.
If the retailer switches to the first-in-first-out (FIFO) method of recognizing inventory
costs, the company considers the older, less-expensive units to be sold first. FIFO
creates a lower cost of goods sold expense and, therefore, higher profit, so the company
can post higher net income in the current period.
Another form of earnings management is to change company policy so more costs are
capitalized rather than expensed immediately. Capitalizing costs as assets delay the
recognition of expenses and increase profits in the short term.
Assume, for example, company policy dictates that every item purchased under $5,000
is immediately expensed and costs over $5,000 may be capitalized as assets. If the firm
changes the policy and starts to capitalize all items over $1,000, expenses decrease in
the short term and profits increase.

Earnings Management Approaches

Companies use several strategies used for earnings management. The most commonly
used strategies are as follows:
1. Earnings-focused decisions
Decisions taken by the management are solely focused on meeting earnings estimates.
The easiest way for earnings management is to control the company’s expenses.
Companies look to cut any optional expenses to meet earnings estimates.
Certain activities – such as research, advertising, or staff training – can be suspended
temporarily. Companies suspend such activities for a short time, assuming that the
business will perform better in the upcoming periods and that the suspended activities
can be resumed thereafter.
However, for companies that are performing well, the management focuses on the long-
term success of the business and does not usually resort to artificially enhancing the
earnings.
2. Biased accounting judgments
Accrual accounting presents opportunities for earnings management; however, a
company’s management needs to exercise some difficult judgments when accrual
accounting is applied.
There are formal policies, accounting manuals, and processes followed at well-
performing companies to ensure that the judgments are bias-free. Earnings
management happens when the management team distorts judgments and mends
policies to meet expectations.
3. Altering accounting principles
U.S. accounting standards provide different rules of accounting for the same
transactions. For example, both the inventory cost and fixed asset cost can be
accounted for in three different but acceptable ways.
The management of well-run companies chooses the accounting rule that best reflects
the implicit economic factors. Earnings management happens when a company’s
management selects an alternative to a certain accounting standard, which will cause
the earnings number to meet expectations.

Identifying Earnings Management

Chartered Professional Accountant (CPA) companies and the Securities and Exchange
Commission (SEC) revelations uncover various types of earnings management used by
companies.
Investors should perform due diligence before investing in the stocks of any company.
Some investors analyze a company’s financial reports and can identify earnings
management.
Listed below are the signs that an investor needs to look for to determine if a company
is exercising earnings management to manipulate its financials:
1. The company claims an increase in revenue without a corresponding increase in
cash flows.
2. The company reports an increase in earnings only in the final quarter of the fiscal
year.
3. The fixed assets of the company are expanding beyond the normal standard for
the industry or company.
4. The net worth of an asset is inflated by ignoring the use of the true depreciation
schedule.

Special Considerations
A change in accounting policy must be explained to financial statement readers, and
that disclosure is usually stated in a footnote to the financial statements. The disclosure
is required because of the accounting principle of consistency.
Financial statements are consistent if the company uses the same accounting policies
each year. This is important because it allows the financial statement user to easily
identify variations when looking at the company's historical trends.
The fact that a change in policy must be explained and that all of a company's accounts
are laid bare in its financial statement means that careful readers will likely discover the
earnings management strategy. The problem is that not everyone has the time to go
over reports in full or the knowledge to understand everything that is written.

Is Earnings Management Illegal?

Changing accounting techniques is not illegal. However, if the SEC deems that a
company is being creative to mislead investors and intentionally misrepresent its results
then it may act and issue fines.

Why Do Companies Engage in Earnings Management?

There are many reasons corporate managers engage in earnings management. These
include higher bonuses, avoidance of falling below closely followed analyst forecasts,
tax savings, boosting the value of the company, and creating a sense of stability.
 Enron
One of the largest and most infamous accounting scandals in American history is that of
Enron Corporation. From the beginning of the 1990s until 1998, Enron was growing at a
respectable rate shown by a 311 percent increase in its stock. After 1999, however, is
when things started to become suspicious. Enron’s stock increased by 56 percent in
1999 and by a further 87 percent in 2000, compared to a struggling economy for those
same years. Enron continued to grow and by December 31, 2000, its market
capitalization exceeded 60 billion dollars, indicating to investors high expectations for
the future. In fact, Fortune magazine did a survey of Most Admired Companies and
Enron was rated as the most innovative large company in America. Nevertheless, by the
end of 2001, Enron’s image and reputation were destroyed. Its stock price plummeted
from a peak of $90.75 in the summer of 2000 to nearly zero in November of 2001,
wiping out shareholder’s equity by almost 11 billion dollars. On December 2, Enron filed
for bankruptcy in New York, becoming the largest bankruptcy in American history at
that time (Bratton 2002). There were many things going wrong at Enron, such as poor
corporate governance and incentives, but one of the most significant was earnings
management. According to Elkind and McLean (2004) in their book, The Smartest Guys
in the Room, “The Enron scandal grew out of a steady accumulation of habits and values
and actions that began years before and finally spiraled out of control.”
Enron: Brief History
In 1985, Enron was founded by Kenneth Lay by means of a merger between Houston
Natural Gas and Internorth, which were two natural gas pipeline companies. During the
early 1980s, most contracts between natural gas producers and pipelines were long-
term contracts, assuring stability in the supply and prices of natural gas. However, by
the mid-1980s, changes in the regulation of the natural gas market occurred, allowing
more flexible arrangements between producers and pipelines. Enron, as a result,
profited from the increased flexibility resulting from the changes because of its
ownership of the largest interstate network of pipelines. Taking advantage of its recent
success, Enron decided to grow by expanding outside its pipeline business and into
natural gas trading. Over time, Enron continued to expand further by becoming a
financial trader and market maker in electric power, coal, steel, paper, and water. By
2001, Enron had become a multinational corporation that owned and operated gas
pipelines, electricity plants, paper plants, and water plants and traded generally in
financial markets for the same products and services (Healy and Palepu 2002).
Focusing on the deregulation of the natural gas market that Enron took advantage of, is
what allowed the company to become so successful. The increased freedom in the
market introduced more volatility in gas prices and suppliers could interrupt the supply
of gas without being legally penalized in a standard contract. Jeffrey Skilling, who would
eventually become CEO, had the idea to create a natural “gas bank” to manage these
risks facing suppliers and buyers effectively. Basically, it would intermediate between
suppliers and buyers of natural gas like a financial banking institution would with money
(Healy and Palepu 2002). This strategy created a comparative advantage over rivals from
the financial sector because Enron could forecast regional shocks earlier because of its
superior knowledge of the industry (Deakin and Konzelmann 2003).
Enron Begins Manipulating Earnings
Eventually, Enron began offering utilities long-term fixed-price contracts for natural gas;
and to reduce exposure to fluctuating prices, it would enter into long-term fixed-price
arrangements with producers. To help finance many of these transactions, Enron began
using off-balance sheet financing vehicles called special purpose entities. By 1992, the
gas trading business became Enron’s second-largest contributor to net income and the
largest merchant of natural gas in North America. In November 1999, Enron introduced
an online trading model called EnronOnline, which further enabled the firm to extend its
abilities to negotiate and manage its financial contracts (Healy and Palepu 2002). Things
seemed to be going well for Enron on the outside, but in reality, because of its complex
organizational structure that stretched the limits of accounting, many ghosts in the
closet were just waiting to get out. These accounting limitations gave Enron the
opportunity to manage earnings to create attractive financial statements (Healy and
Palepu 2002).
Mark-to-Market Accounting
Enron had two main schemes for managing earnings that were founded after the
scandal. The first method of earnings management used that would eventually
transform into a major problem was Enron’s aggressive accounting practices with its
long-term contracts. Instead of accounting for the actual costs of supplying a product
and actual revenues received from selling it when it occurred, Enron used a complex
method called mark-to-market accounting, or fair value accounting. According to GAAP,
this method requires that once a long-term contract has been signed, the seller must
estimate income as the present value of net future cash flows (Healy and Palepu 2002).
However, if used effectively, this accounting rule and other revenue-boosting methods
could create the illusion that a company is extensively larger than it really is (Bufkins and
Dharan 2004). This is the case because the bias that goes into estimating the present
value of net future cash flows is what opens the door for earnings management. Despite
this, the SEC approved the accounting method on January 30, 1992. The ruling only
applied to the trading of natural gas contracts, but Enron would use it in other areas of
the company in order to meet expectations (Elkind and McLean 2004). An example is
when Enron signed a 20-year agreement with Blockbuster Video to introduce
entertainment on demand to multiple U.S. cities. Pilot projects in a few cities were
created to stream movies to a few dozen apartments from servers set up in the
basement. Even though there were still doubts about market demand and the technical
feasibility of this agreement, based on the pilot projects, Enron decided to recognize
estimated profits of more than 110 million dollars. Eventually, Blockbuster pulled out of
the agreement because of its failure, but Enron, on the other hand, continued to
recognize future profits (Hays 2005).
Special Purpose Entities
The second main method involved in the scandal was Enron’s use of special purpose
entities (SPE). SPEs are defined as legal entities created to fulfill specific or temporary
objectives (Healy and Palepu 2002). A company will create an SPE, but an outside
investor will come in to supply external capital and share the risk (Deakin and
Konzelmann 2003). In this way, companies can finance a large project that they want to
be achieved without putting the entire firm at risk. In Enron’s case, SPEs were used to
fund or manage risks associated with assets such as the acquisition of gas reserves from
producers. For financial reporting purposes, there are a series of rules that state
whether an SPE is a separate entity from the sponsor (Healy and Palepu 2002). These
rules made by GAAP again leave room for opportunities to create misleading financial
reports because the rules state that the assets and liabilities of an SPE do not need to
appear on the balance sheet of the sponsor (Deakin and Konzelmann 2003). Enron took
full advantage of these rules and as a result set up hundreds of SSPEswhose accounts
did not need to be consolidated with its own. This enabled Enron to maximize its
benefits of using SPEs. Enron was able to replace potential liabilities with assets such as
promissory notes issued to Enron by its own SPE and increase earnings through income
generated by the SPE (Deakin and Konzelmann 2003). Surprisingly none of these actions
were illegal since they adhered to GAAP. However, Enron crossed the line into fraud by
entering into a series of transactions with an SPE that had no outside investor called
Chewco (Deakin and Konzelmann 2003). In the annual reports, Enron did disclose the
existence of these transactions as required, but in a blurred manner. By violating
accounting standards with the creation of Chewco and other false SPE which were
revealed in October of 2001, Enron was able to understate its liabilities and overstate its
equity and earnings (Healy and Palepu 2002).
Collapse and Exposure
It is evident that towards the end of Enron’s reign on top from 1997 until its collapse in
2001, its primary motivations for accounting and financial operations seem to have been
to keep reported income and cash flow up, asset values inflated, and liabilities off the
books (Bodurtha 2002). But Enron’s phenomenal four-year growth from 13.3 to 100.8
billion dollars was tainted with the use of a variety of deceptive, perplexing, and
fraudulent accounting practices. Enron awed everyone, including Wall Street, with its
continuous growth, even in the down energy and utility industries. But it was all a scam
and the best analysts during that time were tricked with the rest (Bufkins and Dharan
2004).
The discouraging truth is that some in Congress claim that Wall Street analysts should
have seen red flags as early as two years before Enron’s implosion. Instead, analysts
rated Enron stock as a strong buy on the same day that Enron acknowledged it had
overstated profits by almost $600 million (Cohan 2002). Even though Enron’s financial
statements were described as opaque and impenetrable, there were still signs of
suspicious activities. For example, Enron’s return on equity and profit margins showed
that it wasn’t profitability that drove its stock prices up because it ranked at the bottom
of the largest energy companies. This would suggest a major weakness in the company’s
financial foundations regardless of how much debt was hidden in special purpose
entities and concealed from the public. When it seems like a company is too good to be
true, it probably is. Bufkins’ and Dharan’s (2008) numbers point out that Enron’s growth
of over 65 percent per year is unprecedented in any industry, let alone an industry like
the energy one which considers a two or three-percent-a-year growth decent. If Enron
would have continued to grow at the pace it was at, it would have surpassed Walmart as
the world’s largest company (Bufkins and Dharan 2008). Towards the fall of Enron,
executive Sherron Watkins noticed these questionable actions and informed CEO Ken
Lay of them, but he seemed to just not comprehend the seriousness of the situation. In
fact, the optimism of Mr. Lay continued even after explicitly being warned that several
years of improper accounting practices threatened to bring down the company (Cohan
2002). It is possible that Mr. Lay acted obliviously because of the fear of the public
finding out about his involvement. According to Bufklins and Dharan (2004), it is very
probable that the linkage of revenues with executive compensation is a leading factor in
Enron’s focus on boosting its total revenue figures. Some evidence provided in Enron’s
annual proxy statements showed that the level of compensation of its key executives
was linked to reported revenues under the description of compensation plans. For
example, Hewitt Associates executive compensation survey which is generally used to
compare competitive pay levels related to revenue size, reveals that CEO Ken Lay was
paid a lot of money compared to the average. In 2000, his total compensation was 40.8
million dollars which is 62 percent higher than the 25 million dollars for a 100-billion-
dollar company (Bufkins and Dhara 2004). Clearly, the numbers point out that Lay was
involved and aware of the illegal activities going on within the company.
Conclusion
General Electric and Enron were both involved with earnings management. One is still
around today, while the other is not. This is what makes earnings management such a
risky business with which to become involved. It has the potential to give the impression
that a company is impervious to a bad year, which in return creates an attraction to
investors. But it also has the power to undermine an entire company in a matter of
months. There is undoubtedly a large gray area when it comes to the legality of earnings
management and fraud because of the difficulty in detecting violations of accounting
standards. However, there is a distinction between earnings management that will
destroy a company and methods that will smooth a company’s reported earnings,
whether that being neither too high nor too low. After examining Enron and GE’s
actions, Enron evidently stands out more when it comes to fraudulent activities, ending
in its economic failure. Besides Enron, there are many other companies that went under
over the past decade, and often earnings management was exposed as a central cause.
Going back to Parfet’s idea about “good” and “bad” earnings management, it appears
that there is a correlation between “bad” earnings management and the failure of
companies. Enron might have begun with aggressive accounting practices using mark-
to-market accounting and special purpose entities with no intention to take it a step
further. Their actions at the time adhered to GAAP, even though they were a bit
questionable. Eventually, though, they crossed the line from “good” to “bad” when they
created false special purpose entities and exaggerated future revenues through the
mark-to-market method.
General Electric, on the other hand, began using earnings management just like Enron,
but never blatantly crossed the line. For the most part, they created a financially stable
company that continued to meet analysts’ expectations without violating accounting
standards. Using General Electric Capital to smooth earnings could be considered
deceitful to stakeholders, but it wasn’t unlawful. In 2009, when GE was charged with
multiple violations of federal securities laws for using improper accounting methods to
increase revenues, GE settled the dispute by paying the penalty. The company didn’t fall
apart like Enron. It was just a minor setback that slightly hurt its image, but nothing
more. GE was still financially stable because it didn’t use earnings management to
create false revenues in order to be the most profitable company but to meet
expectations. Companies like Enron who used earnings management to fallaciously
create revenues or hide liabilities always end up being caught, but they still do it
anyway. These companies rationalize their decisions by stating that it is in the best
interest of the company. They believe that they will be able to fix it later on and
convince themselves as well as others that this is true. The unfortunate thing is that
when a company creates artificial entries, there is no turning back. The company might
look good on the exterior when there is nothing to back it up.
Therefore, the important question a company should ask itself is whether earnings
management is worth the risk. If Enron was exclusively the basis for a decision, earnings
management would be considered absurd to become successful. Therefore, “bad”
earnings management is certainly not worth the risk unless a company is looking to be
on top of the world for a few years while being aware that a long fall that is impossible
to recover from most likely awaits them in the future. But what about “good” earnings
management that every now and then crosses into “bad” territory? General Electric
would probably fit this strategy the best and is a great example for others to see
whether it is advantageous or not. For a while, GE was meeting expectations every year,
but that success brought accountability and pressure to match those results in the
future. Consequently, that same pressure compelled GE to take the risk of inflating
revenues to the next level in order to meet expectations. Eventually, their poor
decisions were detected, and they had to face the consequences. Fortunately for GE,
they didn’t overuse “bad” earnings management and recognized their mistake. Ever
since its financial troubles in the spring of 2008, GE has been coming around and
expects growth soon (Layne 2010).
In conclusion, the level of use of earnings management is and will almost always be up
to the discretion of executives. If those executives are smart, they will stick exclusively
to “good” earnings management, but with caution. “Good” earnings management is
always the stepping stone to “bad” earnings management because of the temptation to
build that reputation of flawlessness as GE did. Besides, once a company stretches
revenues beyond reasonable limits or hides expenses, it is nearly impossible to get back
on track. It is best for a company to just allow itself to have a bad year and move on. GE
had to learn it the hard way and is still recovering from the damage, while Enron never
even got a second chance. Hopefully, companies today and in the future will recognize
these risks imposed by earnings management and the SEC will continue to prosecute
those who don’t follow the law. Otherwise, the economy could be in serious jeopardy.