Earnings Management: Definition, Techniques & Examples

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  • 0:01 Earnings Management Defined
  • 0:38 Why Earnings Management?
  • 2:44 Earnings Management Techniques
  • 8:25 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

Earnings management is a hot topic in the accounting world. In this lesson, you will learn what it is, what techniques are most popular and see examples of each.

Earnings Management Defined

A company's number one goal is to make money. Not only do the company owners want to have a profit at the end of every accounting period, but they also want the company financial statements to look as good as they can. After all, the financial statements are what potential investors and creditors look at when they make the decision whether or not to lend the company money or to become an investor.

This is where the concept of earnings management comes into play. Earnings management, in a nutshell, is the creative use of different accounting techniques to make financial statements look better. Now that doesn't exactly sound like a legal thing to do, does it? But, believe it or not, it actually is.

Why Earnings Management?

This was a very hard concept for me to grasp when I was learning it. How could something that seems so illegal actually be legal? And, why would there be the need to dabble on that fine line between legal and illegal? The best way to answer this question is to use the acronym WISE. WISE stands for: Window dressing, Internal targets, income Smoothing, External Expectations.

Window dressing refers to the company's decision to dress up the financial statements for potential investors and creditors. The goal of this is to attract new supporters by having financial statements that look like the company's doing great. The company needs to appear to have a history of being profitable, even if it means lowering profits in one accounting period to increase profits in another. Even though this seems fraudulent, it isn't. Overall, the company is still reporting the same amount of profits, but is spreading the amount evenly over a specific time period.

Internal targets are another reason that a company may choose to use earnings management techniques. Often times, the company has set its own internal goals, such as departmental budgeting, and wants to be sure to meet those goals. No department wants to be the one to blow the proposed budget, so earnings management techniques are used to balance this out.

Income smoothing comes into play here because of the fact that potential investors generally like to invest in companies that have a continuous growth pattern. Smoothing out income generated, when there may be spikes at certain times and drops at others, allows it to appear like the company has that smooth growth pattern.

External expectations comes into play when the company has already made projections as to what their profits will be and investors now expect that exact amount of profits or more. Management may feel the need to shift revenue from one accounting period to another in order to meet the projected goal. Earnings management, quite simply, takes advantage of the different ways that accounting policies and procedures can be applied to financial reporting.

Earnings Management Techniques

Now that you're familiar with some of the reasons why earnings management occurs, let's look at some of the legal techniques that are used. Though there are a number of these techniques, for this lesson, we're only going to look at the top five.

1. The big bath- This technique is often called a 1-time event. What happens with the big bath technique is that an out of the ordinary, or non-recurring, event occurs in a company, and expenses associated with that event are actually inflated. So, how can they inflate expenses and still be within GAAP guidelines? Easily! The company reports all of its expenses, but instead of attributing them to the correct accounts, they're all attributed to the 1-time event. Let me give you an example, and this will help you understand.

Billy owns multiple pizza restaurants. After months of struggling, one of the restaurants just has to be closed. This is a 1-time event and not one that is considered common. Since Billy knows that this loss will already cause a decrease in his reported net earnings, he decides to go ahead and charge a majority of the companies expenses to this business unit shut down.

He also knows that he doesn't want investors and creditors to think that the company is faltering, so he decides to count part of the loss in one accounting period and part in another. When the annual financial statements are printed and made available to the public, the bottom line net profit for the company will be correct.

2. Cookie jar reserves - This technique is also an income smoothing technique. It occurs when expenses are based on estimates. If the company over estimated expenses, then it may choose to use a portion of the expenses in one accounting period and save the other for future accounting periods.

Let's go back and look at Billy again. There was an electrical fire at one of Billy's pizza parlors. Billy hires a contractor to totally rewire the building and make sure that everything is up to code in the restaurant. Since all this happened at the end of the accounting period, Billy took the estimate that the contractor gave him and counted that as an expense for the current period.

When the actual payment was made to the contractor, it was for much less than the estimate, and it was paid in another accounting period. This caused there to be an overage of expenses claimed in the prior accounting period. When it came time to close the books for this accounting period, Billy sees that he made a bit more money that he actually wants to report. He decides to pull some of those expenses out of the cookie jar and apply them to the current period.

3. Operating activities - This earnings management technique occurs when managers plan certain events to occur in certain periods. This means that managers may decide to purchase new equipment in a period where income has been reasonably high. They want to ensure that the income is leveled out with prior periods so that there won't be a spike in some months and dramatic decline in others. Even though they're rearranging the timing of the purchase to best benefit the financial reports, they're still accurately reporting the expense. Once again, let's go back to Billy.

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