Earnings Management

admin — Wed, 17 Jun 2009 18:57:43 +0000

Even though the United States has the tightest accounting regulations of any country, managers still have a lot of discretion when it comes to ﬁnancials. There is also no clear line where accounting judgments become unethical or even criminal. The border zone between ethical and unethical behavior is a ramp of gray—it may be easy when one is in the clean white zone or in the clean black zone, but in between, it is often a slippery slope.
We already know that managers must make many judgments when it comes to accrual accounting. For example, managers can judge overoptimistically how many products customers will return, how much debt will not be repaid, how much inventory will spoil, how long equipment will last, whether a payment is an expense (fully subtracted from earnings) or an investment (an asset that is depreciated over time), or how much of an expense is “unusual.” However, manipulation is possible not only for earnings and accruals but also for cash ﬂows—though doing so may be more diﬃcult and costly. For example, if a ﬁrm designates some of its short-term securities as “trading instruments,” their sale can then create extra cash—what was not cash before now counts as cash! Similarly, we already know that ﬁrms can reduce inventory, delay payments to suppliers, and lean on customers to accelerate payment—all of which will generate immediate cash, but possibly anger suppliers and customers so much that it will hurt the business in the long run. Firms can also sell oﬀ their receivables at a discount which may raise the immediate cash at hand but reduce the proﬁt the ﬁrm will ultimately receive. A particularly interesting form of cash ﬂow management occurs when a ﬁrm is lending money aggressively to its customers. The sales generate immediate cash from sales, and the loans can count as investments. Of course, if the customers default, all the company has accomplished is to give away its product for free.
One quick measure of comparing how aggressive or conservative ﬁnancials are is to compare the ﬁrm to other similar ﬁrms on the basis ratio of its short-term accruals divided by its sales. It is important that “similar” means ﬁrms that are not only in the same industry but also growing at roughly the same rate. The reason is that growing ﬁrms usually consume a lot of cash—an established ﬁrm will show higher cash ﬂow than a growing ﬁrm. If the ﬁrm is unusual in having much higher accruals—especially short-term accruals—than comparable ﬁrms, it is a warning sign that this ﬁrm deserves more scrutiny. Managers who decide to manipulate their numbers to jack up their earnings more than likely will try to manage their accruals aggressively in order to create higher earnings, too. Of course, this does not mean that all managers who manage their accruals aggressively do so to deceive the market and will therefore underperform later on. A manager who is very optimistic about the future may treat accruals aggressively—believing in few returns, great sales, and a better future all around. Indeed, as noted earlier, the slope from managerial optimism to illegal earnings manipulation is slippery. Finally, another earnings warning sign for the wary investor is when a ﬁrm changes its ﬁscal year—this is sometimes done in order to make it more diﬃcult to compare ﬁnancials to the past and to ﬁnancials of other ﬁrms in the same industry.

Financial issues » Earnings Management

Earnings Management