4.3 Earnings Management: Accrual, Real, and Expectations Management
Earnings Management:
Accrual, Real, and Expectations Management[1]
We have already made the point that financial analysts need to be well versed in accounting rules in order to do his/her job well. Analysts rely mightily on accounting data. Thus, we must know what is going on in the corporate accounting world. Reported earnings are subject to all kinds of accounting chicanery, and it is earnings that largely drive stock prices!
Thus, firms have an incentive to “manage earnings” in order to guide analysts’ earnings expectations downward and, thereby, report actual earnings that were greater than analysts’ previous consensus expectations. Corporations cannot legally inform analysts what their exact earnings expectations are, so they employ various mechanisms to guide the analysts.
Stock prices, in the wake of this management, will react bullishly to positive earnings announcements, i.e., earnings that exceed expectations. Such stocks will provide higher returns than those of firms who do not beat expectations,[2] as investors may believe that beating expectations signals positive trends in future earnings. Stocks of corporations that miss expected earnings are penalized asymmetrically; markets penalize stocks more for missed earnings than they reward companies for positive surprises.[3]
Not all potentially misleading accounting data are intentionally “managed” by the firm and its accountants. In some cases, GAAP accounting provides no discretionary opportunities for earnings management, e.g., the choice of either FIFO or LIFO, yet the data may nonetheless not represent true values. An example that we discussed had to do with historical bias. In this case, there is only one way in which a long-term asset can be “booked,” and hence its reported asset and tax depreciation figures are based on that historical cost. The historical record is unlikely to be realistic.
Beyond these examples, inventory can be written down on a discretionary basis within reasonable limits. Reported estimates and reserves can be manipulated within reasonable parameters. Indeed, reserves are fertile ground for manipulation. In order to manage earnings upward, the firm may choose to “under-reserve” the allowance for doubtful accounts. As noted, managed manipulation of accrual accounting methods will lead to varying presentations of the same economic phenomena. AEM, thus, involves the use of the accounting system itself in order to influence a desired result.On the other hand, we have also provided some illustrations of Accrual Earnings Management (AEM) in the manner of Inventory Costing and Reported Depreciation Accounting Methods (as opposed to tax depreciation methods). AEM has to do with GAAP-permitted choices.
Timing the sale of inventory in order to boost earnings in a targeted period. Another opportunity for earnings management comes from Real Earnings Management (REM). In this case, a firm may engage in certain actual transactions in order to accomplish a particular accounting outcome. Specifically, the firm could structure transactions by setting them at varying discretionary points in time (“timing”) in order to achieve a pre-set accounting result. Here are some examples of REM:
- Delaying fixed asset maintenance expenses.
- Delaying operating expenses, including advertising and R&D.
- Putting off salary increases and the payment of bonuses.
- Delaying taking on potentially profitable capital investment projects.
And… guess what? They can do this time and again, over and over. One must be suspicious of what a CEO says on television. Auditors cannot control or influence this phenomenon as financial statements are not involved! We will let you decide if AEM, REM, and PEM legitimately circumvent accounting rules or not, and whether you may consider its use ethical – or not! Third, firms have an incentive to manage the public’s future earnings expectations in such manner as analysts and investors expect less and get more in earnings in reality than had been expected. That is not to say that all companies, at all times, will manage earnings expectations downward. By communicating press releases, meeting with analysts, and giving TV interviews, a firm can engage in Public Expectations Management (PEM). Of course, such manipulations, if that is the correct phrase here, are not affected by the accountant.
Still a final manipulation of earnings may come from fraudulent accounting practices.
In sum, firms can employ any and all of the following four means of accounting chicanery: 1. Accrual Earnings Management; 2. Real Earnings Management; 3. Public Expectations Management; 4. Accounting Fraud. Don’t forget: fraud is illegal!
Note:
This discussion was based on a published paper, which may be found at the following link.
- Read the accounting statements’ footnotes; also read “Management’s Discussion and Analysis”!
- Quality financial statements have repeatable earnings and are not prone to reserves management or any form of AEM; over the long-term, accounting and cash earnings should be approximately the same.
- This section is based on Li, S., & Moore, E.A. (2011). Accrual Based Earnings Management , Real Transactions Manipulation and Expectations Management : U . S . and International Evidence. available here. ↵
- Bartov E., D. Givoly and C. Hayn. 2002. The rewards to meeting or beating earnings expectations. Journal of Accounting and Economics 33 (2): 173-204. ↵
- Skinner, D. and R. Sloan. 2002. Earnings surprises, growth expectations and stock returns or Don’t let an earnings torpedo sink your portfolio. Review of Accounting Studies 7:289-312 ↵