To someone new to the world of finance, the phrase "earnings management" might seem innocuous -- and maybe even sound like a good thing. In reality, earnings management is the act of manipulating a company's accounting to make its profits look better. Earnings-management techniques often aren't illegal, as they conform to the letter of accounting rules, but they can violate the spirit of those rules by presenting something other than an honest, objective picture of a company's finances.
Earnings management isn't about falsifying figures. If a company has $1 million in profit but lies and says it has $2 million, that's simple fraud. Earnings management is more about "moving money around," so a company's profit figures look better in one reporting period, or from one period to the next. One common application of earnings management is "income smoothing" -- shifting earnings from one period to another so that profits look steady and consistent rather than volatile. Say a company expects to have $2 million in profit one year and $500,000 the next. It might try to shift revenue and expenses around so that its books show a profit of $1.25 million each year. The overall figure is still correct, but the business's profits look far more consistent than they really are.
Revenue and Expense Recognition
Under standard accounting rules, a company must record revenue in its books when it earns that revenue -- not when it actually receives payment. Similarly, it must record expenses when it incurs them -- not when it actually pays money. These rules leave room for companies to manipulate their numbers for earnings management. For example, say a company signs a deal on December 1 to buy $1 million worth advertising time on TV over the next two months. The company could recognize the entire expense in December, recognize the whole thing in January or split the difference. If it records it all in December, then that year's profit will be lower by $1 million -- but the company will get a "head start" on the next year's profit by not having any advertising expenses in January. Profits have been shifted from one year to the next with an accounting trick.
Cookie Jar Reserves
Companies shift earnings around by creating overly large reserve accounts in good years, then drawing them down in bad years. For example, when a company sells a product with a warranty, it must recognize the estimated expense of honoring that warranty at the same time it books the revenue. A company might conclude that it incurs warranty costs of $10,000 for every $1 million in sales. If it's having a particularly profitable year, it might decide to take a $30,000 warranty expense per $1 million in sales. That builds up a big warranty reserve now so that the company doesn't have to record warranty expenses in the future, thus shifting profits from one period to the other. This tactic goes by the name "cookie jar accounting," because it essentially stashes excess profits away to be used when needed.
The Big Bath
There will be times when a company simply can't avoid a bad year. No matter what it does, it's going to post a loss because of a sour economy, unfavorable market conditions, legal trouble, whatever. Some companies, though, deliberately make a bad year even worse by shifting all kinds of expenses, one-time charges and write-offs into that year and shifting revenue out of it. This allows it to inflate profits in future years. The reasoning behind this strategy is that if the company is going to "take a bath," it might as well take a big bath. The company's stock price was going to suffer anyway, the thinking goes, and the damage probably won't be that much worse if the company inflates the loss.
Companies of all sizes practice earnings management, although their goals differ. According to a study by researchers at the University of Hawaii, small companies are more likely to use earnings management to try to avoid reporting a net loss in a given period. Large and midsize companies, on the other hand, are more concerned with keeping earnings steady. Wall Street analysts set earnings targets for such companies, and they strive to meet or exceed those targets. They don't want to exceed them too much, though, because that could result in future targets being set even higher.