According to an article posted in “The CPA Journal” by Michael D. Akers, Don E. Giacomino, and Jodi L. Bellovary, earnings management is defined as;
“Earnings management is recognized as attempts by management to influence or manipulate reported earnings by using specific accounting methods (or changing methods), recognizing one-time non-recurring items, deferring or accelerating expense or revenue transactions, or using other methods designed to influence short-term earnings.”
This definition tries to explain that managers have the control to influence the earnings and report them in a way that works in their favor. They do this using the accounting methods, therefore methods allowed by GAAP and find loopholes that are benefitting to them. This same article talks about a survey that was complete by William J. Bruns, Jr., and Kenneth A. Merchant and the conclusions of their survey was then submitted to the Harvard Business Review. Asking readers to rate the acceptability of management practices of 13 earnings management situations. The results as described in the article were “Frightening”. Following observations were made;
“It seems that if a practice is not explicitly prohibited or is only a slight deviation from rules, it is an ethical practice regardless of who might be affected either by the practice or the information that flows from it. This means that anyone who uses information on short-term earnings is vulnerable to misinterpretation, manipulation, or deliberate deception.
We have no doubt that short-term earnings are being managed in many, if not all companies. Some of these earnings-management practices can be properly labeled as immoral and unethical.”
According to this survey, short-term earnings results in misrepresentation, manipulation, deliberate deception or just to make is more simple, It basically results in fraud or fraudulent activities. But because there isn’t much stringent regulation or prohibition, mostly all of the companies use such practices and therefore involved are in fraud. Accountancy thrives on clarity. Managers can choose between the methods of accounting policies to recognize expense, amortization, depreciation or accruals such as inventory values to get the desired target of earnings.
So, if GAAP allows different methods of reporting, that can result in different earnings, why is this a fraud, or to be more specific; when does this become a fraud? Let’s begin with a story where a company wanted to hire a chief accountant and they were in the last stages of their interviewing processes. No one made it through so it came down to one last question that was asked to every candidate; “What are net earnings?” The person who got the job answered, “What do you want them to be?” (Stephen D. Makar, Pervaiz Alam and and Michael A. Pearson). Whether true or not, this explains how a manager would want to influence the earnings. They could be due to high pressure, stocks, if a company wants to earn a contract or maybe...